Retirement Planning and Annuities
Retirement questions test plan types, the tax rules governing contributions and distributions, and the annuity mechanics used to convert assets into income. Expect contribution and distribution rules, RMDs, payout options, the exclusion ratio, and 1035 exchanges.
Qualified plans and IRAs
- Defined benefit plans promise a benefit; defined contribution plans (401(k), 403(b), profit sharing, SEP, SIMPLE) promise only contributions.
- ERISA sets fiduciary, vesting, and disclosure rules. Vesting schedules apply to employer contributions; salary deferrals are always 100% vested.
- Traditional contributions are pre-tax; Roth contributions are after-tax with qualified tax-free withdrawals.
- Required minimum distributions begin at age 73 (rising to 75 in 2033) for traditional plans and IRAs; Roth IRAs have no RMD during the owner's life.
- A 10% early distribution penalty applies before 59½ unless an exception applies: disability, death, substantially equal periodic payments, unreimbursed medical expenses above the AGI threshold, IRS levy, qualified birth or adoption, terminal illness.
- Non-spouse beneficiaries generally must empty inherited accounts within 10 years under the SECURE Act.
Annuities
Immediate vs deferred; fixed, variable, and indexed. Accumulation phase, then annuitization or periodic withdrawals. Nonqualified annuity withdrawals before annuitization are taxed LIFO - gains first, then basis - with a 10% penalty before 59½. Once annuitized, the exclusion ratio separates return of basis from taxable income. Payout options: life only (highest payment, no refund), life with period certain, installment refund, joint and survivor (lower payment, covers two lives). A 1035 exchange moves life to life, life to annuity, or annuity to annuity tax-free; annuity to life is not permitted.
Worked example
A client invests $100,000 in a nonqualified immediate annuity paying $600/month over a 20-year expected return (240 payments = $144,000). Exclusion ratio = $100,000 ÷ $144,000 = 69.4%. Each payment excludes $416.67 from tax and includes $183.33 as ordinary income.
Traps
Using 70½ for RMDs; treating annuity withdrawals as FIFO; forgetting the 10% penalty; assuming joint-and-survivor pays more than life only; thinking a 1035 exchange can move annuity money into a life policy.